For decades, management studies have sought to identify the qualities that distinguish the truly great companies from the rest. Such studies often have focused on what actions companies and their leaders have done to achieve high performance—actions that can’t necessarily be replicated by other organizations for various reasons.

Perhaps a more useful guide is how exceptional companies think and how the decision-making rules they seemed to use propelled the truly great performers into long-term success. In their book, The Three Rules: How Exceptional Companies Think, (Portfolio/Penguin, May 2013) authors Michael E. Raynor, director, Deloitte Services LP and author of The Strategy Paradox, and Mumtaz Ahmed, chief strategy officer at Deloitte LLP, identify three rules that capture how high-performing outliers deliver superior performance over the long run, despite facing the same constraints as competitors:

Rule No. 1: Better before cheaper: Compete on differentiators other than price.Rule No. 2: Revenue before cost: Drive superior profitability with higher prices or higher volumes, not lower cost.Rule No. 3: There are no other rules: Change anything/everything in order to abide by the first two rules.

In this first of two interviews, Dr. Raynor and Mr. Ahmed explain how they reached their findings, based on research spanning more than 25,000 companies from hundreds of industries over a 45-year period, and what those findings can mean for companies looking to improve their performance trajectory.

Q: Before you began your research into what would become The Three Rules, what did you see as lacking in research on what makes companies outstanding? What was the void you were hoping to fill?

Mumtaz Ahmed: The simple answer is most of the research that had been done wasn’t looking at the right companies or looking at them in the right way. A lot of the research was really long on story and short on fact and analysis, especially facts rooted in the financial realities of those companies’ results over time.

Michael Raynor: Many of those studies were flawed simply from a perspective of the research method. A book like In Search of Excellence attempts to understand what makes for great companies without comparing great companies with less-than-great companies. So the way in which the conclusions are reached doesn’t give reason to believe that they’re right. That’s not to say the conclusions are wrong. But from a straight methods perspective, a lot of the work that falls into the category of a success study fails. In our book, we took on the problem of answering a seemingly small question, which is, how do you know what constitutes superior performance?

Q: In your research you chose to focus on return on assets (ROA) as your measurement benchmark. Why that measure and when did you decide to focus on it?

Mumtaz Ahmed: We picked ROA because it reflects to a significant extent what management has done to affect performance. Other measures seem to us to be affected by factors outside managers’ control. For example, total shareholder return and share price are subject to the vagaries of investors’ expectations.

Variations on ROA, such as return on equity, return on capital employed, return on invested capital, and so on, can also work, but we chose ROA because that is likely to capture the outcome that is as directly related to management behavior as possible and reflects the outcomes of strategy execution. As an added bonus, ROA can be broken down into its constituent elements, that is, gross margin, asset turnover, and so on, allowing us to connect specific behaviors to specific performance outcomes.

Michael Raynor: We wanted to understand what makes for a great company, not what makes for a great investment. Companies can be highly profitable and consistently so while delivering only market average returns because everyone has figured out that they are highly and consistently profitable. Measures such as share price are certainly important, but they are important to other constituencies for other reasons.

Q: How did the three rules—better before cheaper, revenue before cost, and there are no other rules—evolve from your research?

Michael Raynor: We were looking for patterns of behaviors that connected specific activities, such as innovation and growth and R&D, to superior performance and those patterns just never showed up. We began to extract order from the chaos when we shifted our focus from how companies behaved to the decision-making rules implicit in the choices the companies made over time. We can’t say that’s why the people who ran those companies made those choices at that time. But if we look at the big choices which we have strong reason to believe made the difference for success, we can infer the kinds of decision rules that are consistent with those choices, namely, better before cheaper and revenue before cost.

Mumtaz Ahmed: One obvious area that we looked at in our research was deal activity. The key questions were, “Do great companies do more deals or fewer deals?” and “Do they do different types of deals?” Interestingly, we found patterns in deal activity that were sometimes common to the highest-achieving companies, which we called Miracle Workers, as well as to the ordinary performers, which we called Average Joes. Average Joes did lots of deals in one sector and very few in another and similarly for Miracle Workers.

The point is, that by examining that kind of activity alone, we were not able to find any patterns that would explain the companies’ performance. But when we were able to link their patterns of dealmaking with a higher purpose—the higher purpose here being better before cheaper and revenue before cost—we could make sense of them. The more persistently these rules are pursued, the better the odds of beating the competition and the odds of becoming truly exceptional.

Q: Based on your research, which companies stood out for following these rules?

Michael Raynor: Keep in mind that we wanted only those companies that were good enough for long enough that we could be confident something special was going on. We wanted companies that were truly exceptional. To that end, we analyzed nearly 300,000 company-​year observations from 1966 to 2010. From that universe we identified a population of 344 exceptional companies. From this population of exceptional companies we selected a representative sample of trios, three companies from each of nine industries. Each trio consists of a Miracle Worker, a Long Runner, and a third company of average performance that we call an Average Joe. By comparing the very best with the very good, and both with the merely average, we hoped to shed light on two different types of exceptionalism. First, what does it take to pull away from the pack, that is, how do Miracle Workers and Long Runners separate themselves from Average Joes? Second, how do Miracle Workers—the very best—pull away from Long Runners—the very good?

Mumtaz Ahmed: We also found that the companies in the nine trios made systematically different choices across a wide range of issues. The Miracle Workers consistently put better before cheaper and revenue before cost, and the Long Runners to a somewhat lesser extent.

Michael Raynor: Regardless of circumstances and constraints, our top performers were doggedly persistent only in their adherence to the first two rules. Expansionary markets? Better before cheaper; revenue before cost. Recessionary economy? Better before cheaper; revenue before cost. Technological disruption? Better before cheaper; revenue before cost. Plague of locusts? Zombie apocalypse? Better before cheaper; revenue before cost.

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